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In 2004, Congress passed a law that changed how deferred compensation was taxed. If a compensation package satisifies the rules in Section 409A then when stock is used as compensation, it is taxed right away rather than at redemption (say when there is an acquisition or IPO). Some CPAs predicted it would change how firms pay CEOs. Has this law impacted

  1. a startup's decision to pay a new hire with equity?
  2. the composition/type of equity that is paid?

If it does, it would possibly alter the kind of people that a startup can hire and even how much VC money has to be raised (because they need cash for salaries).

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409A applies in many different instances, but the one you are most concerned with is how 409A affects the valuation of stock options.

Generally speaking, if the value of the stock option is too low, and the IRS audits you, then they will set the value of the stock option at the fair market value of what they determine your stock price to be, and charge you a 20% excise tax "penalty" as a result of valuating your stock too low as well.

The remedy for this is to make sure that your valuation of your stock options is actually equal to or greater than what you think it is actually worth so the IRS can't come back and say you were selling options for less than it was worth.

Another option is to grant Incentive Stock Options, which are technically not subject to 409A, or founders restricted stock, which is also not subject to 409A instead of regular stock options.

Note: This is not legal advice, nor does this create an attorney-client relationship.

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Startups don't really pay employees by issuing direct equity; they issue options with the strike price set at the current value of the stock. Because the IRS allows you to value such an option at zero, even though it has economic value, the employee doesn't have to pay tax on the receipt of the option. That makes everyone happy... you pay the employees with paper, not money, and they don't have to pay any taxes on that paper until it's actually worth something.

The big impact of 409A was that the strike price of the option really has to be the current value of the stock. You can't give someone the right to buy $1 of stock for $0.01 and then pretend that you haven't given them something of value. The practical impact has been that startups are more careful about setting the strike price, often hiring experts to do valuation projects and determine how much the stock is worth at the time of the options grant.

Essentially this just created an added expense of around $5000-$10000 for the valuation project, but in the long run shouldn't really make much of a difference.

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